Reconstitution of the firm may happen under any of the following circumstances and as a result there will be a change in the profit sharing ratio: 1) Change in the profit sharing ratio amongst the existing partners; 2) Admission of a new partner;
3) Retirement of an existing partner;
4) Death of a partner and
5) Amalgamation of two partnership firms
Change in the profit sharing ratio of existing partners:
The partners of a firm may decide to change their profit sharing ratio and in such eventuality, the gaining partner (i.e. the partner whose share has been reduced) unless otherwise agreed should be paid some compensation and the compensation is the value of goodwill represented by the gain because the change in profit sharing ratio means that one partner is purchasing from another partner of the profits.
For example; James and Jones, two partners of a firm are sharing the profits of the firm in the ratio of 3:1 and if it is decided that in future both will be equal partners, it means that James is selling to Jones ¼ th (3/4-1/2) share of profits. Therefore, Johns will pay to James an amount equal to one fourth of the total value of goodwill. In concrete terms, suppose, the profit is $20000 previously James would get $15000 and Jones would get $5000. After the change in the profit sharing ratio, each would get $10000. James, therefore, loses annually $5000 and Jones gains $5000. If the goodwill is valued at $40000, Jones must pay James one fourth of $40000 namely $10000. This adjustment is usually made by passing an adjustment entry. In this case, John's capital account will be...